So, What, Exactly, is “Quantitative Easing” and, More Importantly, Why Should I Care?

As with many things in the current zeitgeist, “quantitative easing” is a phrase commonly bandied about but little understood. To that end, Felix Salmon has posted a great interview with Greg Ip about what, exactly, quantitative easing is.

Here’s how QE works. The Fed buys a $100 bond from Bank of America. The bond gets added to the Fed’s assets. Bank of America has an account at the Fed. The Fed, with a keystroke, puts a $100 into B of A’s account. Where did the money come from? Thin air. Bank of America can visit its friendly neighborhood Fed branch and withdraw that $100 in the form of bills and coins. So for practical purposes the distinction between currency and reserves is meaningless; the monetary base includes both.

Incidentally, it makes no difference whether the bond belonged to Bank of America, or a customer of Bank of America; the mechanics are identical. When the Fed buys the bond from someone who isn’t a bank (e.g. a primary dealer), the transaction is settled through that person’s bank.

The Fed can also unprint money. Suppose its sells the $100 bond back to Bank of America. It then deducts $100 from B of A’s account at the Fed. The money disappears from existence.

You could argue at a more abstract level that this is not printing money. Normally we treat the Fed as independent of the government. Its liabilities, namely currency and reserves, are therefore not liabilities of the government, like treasury bills and bonds. When the Fed buys a Treasury bond, the liabilities of the Fed (reserves) grow but the liabilities of the government stay the same.

If instead you treat the Fed as an integral part of the federal government and merge their balance sheets, then QE simply takes one liability (a Treasury bond) out of circulation, and replaces it with another (reserves). This is actually a core criticism of QE: that in a liquidity trap, investors don’t really care if they own cash or Treasury bills and replacing one with the other accomplishes nothing.

In the real world I think the two should be, and are, treated separately. The Fed as far as we can tell is acting independently. It doesn’t have to buy Treasury debt; it could theoretically conduct QE by buying private sector or foreign debt.

This is very incisive and informative stuff, and there’s lots more at the link that you should read.